Dollar Dropping to New Lows?
Dollar declined for the second week in a row as the economic data produced nothing but drab news. CPI continued to press higher with core readings reaching 2.5% while headline prices clocked in at 4.3% as rise in commodities showed that inflation is very much alive. But price stability is not a concern for the Fed at the moment. US monetary policy are solely focused on reviving growth. This week horrendous reading in the Philly Fed index which reached a 7 year low, was a loud and clear signal that demand is contracting rapidly. Add to that the fact the weekly jobless claims have averaged well above 350K for the past four weeks and it becomes easy to see that markets now expect another 50bp cut in March.

As we noted last Monday, “In the past few weeks, the euro has come under heavy assault on fears that ECB will soon be forced to follow the Fed towards a more accommodative monetary policy. However, if market perception changes, with traders coming to a consensus that EZ rates will remain at 4% for at least the first half of 2008, the unit could regain its upward momentum and challenge new highs as interest rate differential dynamics come back into play.”

Next week the calendar is quite busy but most the data will be second tier. The one exception to that rule is the Durable Sales report due on Wednesday. The market expects a massive decline to -4.0% from prior months jump of 5.0%. If the news confirms the dour forecast the dollar may see further selling as the notion of an oncoming recession will begin to solidly in the market. However, if the report surprises to the upside, it could prove to dollar positive suggesting that maybe, just maybe economic demand is more resilient than most traders believe. In short, it promises to be another volatile week as prices in EUR/USD approach record lows once again.

Euro – Decoupling or Not?
On Friday The flash estimates for Eurozone PMI services surprised to the upside printing at 52.3 versus 51.0. Contrary to consensus calls of a slowdown, the PMI services component saw gains in employment and new orders, strengthening the ECB’s argument that the Eurozone economy remains string enough to weather the current credit crunch without the need for monetary easing.

As we noted in our daily, “The euro bulls argument that the two largest economies in the world are in fact decoupling in their growth outlooks, received a strong boost from the PMI releases. For the near term, the price action in the pair is likely to be driven almost exclusively by US news. With Euro-zone economic growth slowing only slightly leaving rates in the region stationary at 4%, the only real question for the market is how low will US rates go if the US economy begins to contract. If the Europeans can continue to expand albeit moderately, while US experience an actual decline in GDP growth, the pair could easily break the 1.500 barrier as dollar sentiment will sour further.”

Although the focus will be on US next week, there is one piece of EZ data that could derail any potential EUR/USD rally. The IFO report is due on Tuesday with markets looking for print below the 103 level. If the IFO does indeed show significant weakness, all the hand wringing about ECB being too hawkish could drive the pair right down to the bottom of the recent range. However, should IFO remain at last months levels the case for decoupling will only grow and the pair could make a run to new highs as the decupling thesis will be confirmed.

Yen Looking to a Healthy Mix of Risk and Data for Direction
A week of congestion ended with a breakout in the yen’s favor last Friday as risk sentiment overwhelmed the few economic indicators that lined the Japanese economic docket. In the week through the 22nd, there were very few market moving economic indicators, though where these numbers were lacking in market impact they offered made up for it with a broad look into the health of the world’s third largest economy. The December Tertiary report printed a worst than expected 0.6 percent contraction which inevitably weighed on the Friday All-Industry Activity Index for the same period. A 0.2 percent drop in activity marked the first back to back contraction in nearly a year, suggesting businesses were suffering from rising pessimism among domestic consumers and cooling demand for Japanese goods abroad. The Merchandise trade account delved more deeply into export activity. The first deficit in a year was the product of the yen’s strong rally and waning US demand. Despite the negative reading from the trade report though, exports did improve over the month as demand from China and Russia filled in for the slump in US orders. This is a promising dynamic, but can it last?

Outside the confines of the economic docket, there was a tangible interest in risk developing behind the yen’s ebb and flow. For most of the week, the market was fleeing from its risky positions. The cost of credit default swaps (used to protect investors from corporate bond risk) continually won record highs through the week. This fear was fed by reports that major bond insurers were attempting to split off their subprime units (and opening $580 billion in assets open to downgrades), news that the UK government would nationalize troubled lender Northern Rock (and thereby admitting the problem was severe) and deepening fears of a US recession. However, at the last minute, risk appetite found a little reprieve with news a bail out plan may be put into action for insurer AMBAC next week with a $2 to $3 billion dollar injection from a number of banks. This could turn risk trends this week, if the market is finally comforted that debt won’t be downgraded.

Beside the volatile whims of risk appetite/aversion, the economic docket will undoubtedly have its influence on growth expectations, if not the yen itself. Kicking the heavy data off on Wednesday, industrial production is expected to cool over January thanks to steadily rising costs and fading domestic and foreign orders. Inflation trends on the other hand are expected to maintain their upward momentum (mimicking the growth/price tradeoff in the US and UK). Core inflation is expected to hit a 0.9 percent annual pace – setting a new 9 year high. Along with an expected uptick in the jobless rate, rising costs should begin to weigh on consumer spending; but not for January according to market expectations. Household spending is expected to grow 0.3 percent and retail sales 1.8 percent over the same period.

British Pound Recovers as Inflation may Prevent BOE Rate Cut in March
It was a rocky week for the British pound, as bears took advantage of the dovish Bank of England MPC meeting minutes from February to drive GBP/USD down to 1.9361. Indeed, the minutes revealed an 8-1 vote to cut rates by 25bp to 5.25 percent, as über-dove David Blanchflower dissented in favor of a 50bp cut to 5.00 percent. However, Blanchflower cited concerns that UK data was similar to prior US data, suggesting that embarking on an aggressive rate cut cycle may be necessary to avert a US-style credit crunch and possible recession. Indeed, his concerns are well-warranted, especially as Northern Rock becomes nationalized, the housing sector slows, and consumption begins to deteriorate. However, other MPC members noted a risk that faster inflation may only stoke expectations, which seems especially pertinent after crude oil hit a new high of $100.32/bbl on Wednesday. Furthermore, the BOE’s Quarterly Inflation Report - which was released just last week - indicated that CPI could breach the 3.0 percent level this year, which would force BOE Governor Mervyn King to write a letter to Chancellor of the Exchequer Alistair Darling explaining how the bank plans to bring inflation back to target.

That said, there is very little chance that the BOE would even consider raising rates to offset these upside inflation risks, as the downside risks to growth are far too large. Indeed, the bank is far more likely to cut again this year, but given the hawkish inflation concerns revealed in the MPC meeting minutes and in the Quarterly Inflation Report, the chances of another 25bp reduction in March are small. The markets took this into consideration when UK retail sales proved to be much stronger than expected, which helped propel GBP/USD on a 250+ point rally.

Looking ahead, this week’s economic data isn’t like to sway market expectations significantly, as UK GDP for the fourth quarter will likely only confirm what we already know – the economy slowed at the end of the year – while GfK consumer confidence is anticipated to fall back. As a result, the direction of US dollar trade may be the critical determinant of where GBP/USD heads next, but given the recent reversal in trend the pair may be angling for a push to 2.00.

Swissie Gains on Strong Data, Will Risk Aversion Come Back into Play?
The Swiss franc ended the week on a stronger note with the help of a softer US dollar and some better-than-expected economic data. The Swiss trade surplus widened more than expected in January, as the balance rebounded to 1.22 billion francs from 0.2 billion francs in December. Indeed, it appears that demand in emerging markets like China is helping to offset declining orders from the Euro-zone, as the 15-nation region faces an economic slowdown. However, with cooler growth anticipated to impact the global economy, Swiss exports may only find limited support from Asia. Furthermore, once producers cut back on output more significantly, this will eventually start to dent labor market conditions and domestic demand - a major contributor to the economy - which does not bode well for Swiss expansion this year. Meanwhile, inflation pressures continue to build in Switzerland as producer and import prices rebounded in January. Indeed, the producer price index jumped 0.6 percent while the import price index gained 0.5 percent, which was primarily the result of rocketing commodity prices. Nevertheless, the news will be disconcerting for the Swiss National Bank, as they weigh the challenges presented by upside inflation risks and major downside risks to growth. Nevertheless, the SNB is likely to follow the lead of the European Central Bank, which last left rates unchanged despite tighter credit market conditions.

Looking ahead, the status of risk seeking behavior in the market could be a major driver of Swiss franc trade. To a certain degree, the financial markets have stabilized over the past week and trades have not been as risk averse, which has allowed carry trades to appreciate slightly. If this sentiment becomes shaken and equity markets – particularly in the US – begin to break down, FX traders may flock to buy up currencies like the Swiss franc and Japanese yen. On the other hand, Swiss economic data scheduled to be released over the course of the week will likely show that growth in the country has peaked, with consumption and the KOF leading indicator anticipated to fall back. If the news is extremely disappointed, the releases could weigh on the Swiss franc. However, when risk aversion/seeking behavior becomes a dominant force in the market, Swiss fundamentals have very little bearing on the national currency.

Canadian Dollar Sees End-Of-Week Selloff as Data Falters
A mixed week of data keep the USD/CAD pair range bound, locked in between the 100 and 200 day SMA’s, where it has settled for most of 2008. Bearish loonie sentiment was fueled when Canadian core CPI eased 1.4% to its slowest pace since July, 2003 clearing the way for a March BoC rate cut. The MPC has been reluctant to follow the Fed on a path of multiple rate cuts, but recent data from the U.S. and Chairman Bernanke’s dovish comments has reinforced the belief that Canada’s main trading partner may already be in a recession. In order to prevent a similar downturn in their own economy they may have to be just as aggressive. The source of the BoC’s reluctance has been strong domestic demand, which is now showing signs of weakening, as retail sales printed at 0.6% versus expectations of 0.8% in December. The sales ex automobiles showed an underlying weakness as it declined for the first time in five months by 0.4 percent. Overall, outside of a recent boom in car sales due to price reductions, the Canadian economy has begun to feel the affects of slowing U.S. demand.

After approaching resistance levels mid-week, record oil prices and an influx of foreign investment into Canadian mining companies led investors to buy the loonie and send the pair back towards parity. The global demand for commodities will continue to be a source of growth for the Canadian economy as developing countries continue to show signs that they can withstand a U.S. slowdown. However, oil which hit a record 100.10 a barrel, has eased on increasing supplies and speculation that global demand may slow. If demand for commodities starts to slow we may see the pair break through resistance levels before the BoC’s rate decision.

A barren economic calendar for most of the week, will leave traders debating the impact of a U.S. economic slowdown and commodity prices on the MPC’s decision and whether a quarter or half point rate cut is coming. Event risk will come from the U.S. economic calendar, until Friday’s release of the current account - which is expected to produce the first deficit since 1999.

RBA Minutes Rally Speculation of a Hike and the Australian Dollar
A new week has brought a new high for the Australian dollar. The commodity currency sustained its steady advance for a fourth week as dour, global interest rate speculation continued to highlight the appeal of the Australian benchmark lending rate. The key to the currency’s momentum was the minutes from the RBA’s February 5 monetary policy meeting released on Monday. A hawkish bias was fully expected given Governor Steven and his colleagues’ decision to lift the overnight lending rate 25 basis points to an 11-year high 7.00 percent. However, what the market read was far more hawkish than most had expected and ramped up expectations for at least one more hike in March. According to the policy group, the decision between a 25 basis point and 50 basis point rate hike was “finely balanced.” The decision to tighten only quarter percent was eventually decided on as officials suggested the market had already delivered its own hike as commercial institutions have had to lift their rates to compensate for the global credit crunch. Such a hawkish lean plays well with an equally inflationary quarterly monetary policy statement released the week before and core inflation well outside the tolerance band at 3.5 percent.

The minutes clearly gave the Australian dollar a marked boost, as AUD/USD easily cleared resistance seen around 0.9100. As the week wore on, there was little interference from other scheduled events for crossing the wires. The Wage Cost Index for the forth quarter maintained the outlook for inflation trends that would not correct themselves. According to the government’s data, Australian wages grew 4.2 percent – matching the fastest pace of growth since records began back in 1998. Besides this report, the rest of the data for the week fell to the third rung status and allowed the Australian dollar to advance with economic impunity.

Over the coming days, the economic docket is looking to only a few scheduled reports – though any of the indicators could dent the Aussie’s steady rise. Up first is Wednesday’s fourth quarter reading of construction activity. The housing market is still a strong component of consumer wealth and confidence, not to mention growth component. On the following day, the Conference Board’s Leading Index for December will provide an outlook for growth trends over the coming three to six months. However, like the Westpac’s report, the fourth quarter GDP report do next week will likely render this data irrelevant in the market’s eyes. Finally, Friday will bring the fourth quarter measure of consumer lending through January. This will be a good measure of consumer’s appetite for credit and spending against the backdrop of global credit market problems and a hawkish central bank. On the whole though, this week’s data will likely be glossed over as speculation surrounding the following week’s GDP, retail sales, trade reports and RBA rate decision will keep traders’ eye on the horizon.

New Zealand Dollar Closes in on 26-Year High
The demand for yield proved to be a stronger force in the market than the fear of risk. Though there were few major economic indicators scheduled for release over the past week and the interest rate outlook for the RBNZ was still more neutral than it was hawkish, the New Zealand dollar was still able to outperform its Australian counterpart (which came fully equipped with a recent rate hike and heavy speculation of another one to come in March). Through Friday, the kiwi had posted seven consecutive daily advances against its US counterpart; and this despite the tales of risk that left many traders unsure about selling low yielders like the yen and the franc. Nevertheless, the currency is up nearly 700 points from its January 22 swing low and only stones throw from its 26-year high set at 0.8007 last July. No doubt, this milestone will egg kiwi bulls on, calling for at least a toe over the landmark level and perhaps even a rally into record breaking territory.

While the lure of a record high has kept kiwi bulls on the charge, there has be little, recent fundamental push to this impressive move. The economic calendar was virtually empty last week – with only two economic indicators present to hold event risk traders over. Business NZ’s Performance of Services Index for January was the first indicator to cross the wires with disappointing results. According to the survey, activity in the economic sector slowed for the second consecutive month as sales and new orders dropped. The saving grace for the report was the pick up in employment which boosts consumer confidence. And, speaking of the consumer, the credit card spending over the same period unexpectedly rebounded from an 11 month low. This was unexpected given that credit is more expensive as banks try to compensate for the instability in the lending markets and inflation has raised the cost of living.

Over the coming days, the economic calendar will fill out; but the data will likely take a back seat to the demand for yield and the kiwi’s personal mission to overtake a multi-decade high. Nevertheless, the calendar opens up with a new indicator: the RBNZ’ s two year inflation forecast, measured each quarter. And, with the first quarter CPI data not due until April, this report may hold rate watchers over. Later that same day, building permits will measure housing sector activity. A fifth consecutive decline would be mark the worst conditions for the housing market in seven years and could mark the first major crack in growth and the RBNZ’s persistently hawkish front. After that the NBNZ’s five and a half year trend underwater will print a new reading and the trade account will be measured for the influence of waning global growth and a quickly appreciating New Zealand dollar on demand for the nation’s exports.

Boris Schlossberg is a Senior Currency Strategist at FXCM.